Banking Industry Iran; current status, opportunities and threats

iran banking industryThere are 30 banks and 5 financial/credit institutions active in Iran, where banks are the main source of funding for development plans and companies. The Iranian banking industry makes up for 2.5% of GDP and has the second highest penetration rate in the MENA region.

Iran's modern banking industry has a 95-year history. Modern banking in Iran was introduced and dominated by foreign banks up to the late 1920s. The foreign banks, despite their early contribution in introducing many financial innovations, did little to foster indigenous economic development. In 1960 the Iran central bank was established. Later legislation further defined its powers and responsibilities. The banking laws limited foreign participation to 40 percent in any bank operating in Iran (except the Soviet bank, which had been founded much earlier). Subsequently, the Central Bank limited foreign ownership in new banks to 35 percent.

In 1979, after the Iranian Islamic revolution, all banks along with a number of other financial and industrial establishments were nationalized, and the governor of the central bank was inaugurated. The nationalization and the subsequent consolidation of the banks paved the way for the launch of Islamic banking. Nowadays, Iran's banking system is 100% Sharia compliant (The highest of any country), far exceeding that of Saudi Arabia, Kuwait and Brunei, which are all less than 50%.

Currently, there are 30 banks and 5 financial/credit institutions active in Iran, where banks are the main source of funding for development plans and companies. The Iranian banking industry makes up for 2.5% of GDP and has the second highest penetration rate in the MENA region.

20 Iranian banks have been listed on the Tehran Stock Exchange. Currently the government plans to expand the use of online banking and to modernize the banking systems that are at the moment far from international standards. The following figure illustrates the hierarchical structure of Iran’s banking sector. As it is depicted, there are 3 different types of banks in Iran, and all of them are under the rule of the central bank.

Key Players in Iran’s Banking Industry

There are many players in the Iranian banking industry, which can be categorized into 2 major groups, namely internal and external. The first group contains the direct players and the second is constituted of businesses related to the industry. Melli and Saderat are the banks with the largest number of branches and employees. According to the Industry Management Institute IMI100 2015 ranking (top one-hundred companies list announced by IMI every year), Melli Bank is the most valuable holding in the banking industry and the third among all industries in Iran.

Islamic banks are those banks that follow Islamic Sharia (the body of Islamic law) in their business transactions. Among other things, Sharia prohibits dealing in interest and undertaking transactions with unknown fate, while it requires transactions to be lawful (halal). Abolishing interest from their dealings is the fundamental principle on which Islamic banks are based. Use of Riba (usury) violates the principle of social justice, which is very important in Islam, because it leads to rewarding people without them making an effort. Those who lend money on interest do not make an effort, nor do they participate in the risks of the projects financed, and such behavior is rejected by the teachings of Islam. Interest-based transactions allow lenders to receive the advantages associated with lending their money, while avoiding the risks and losses attached to ownership.*

Since 1983 Iran adopted the non interest banking system and applies Islamic principals to the financial industry. While there are differing views about its performance in Iran, all agree that the industry needs improvement.

Central Bank Description:

"BANK MARKAZI JOMHOURI ISLAMI IRAN" is the Central Bank of the Islamic Republic of Iran. The Central Bank of Iran (CBI) was established in 1960. The CBI is responsible for the design and implementation of the monetary and credit policies with due regard to the general economic policy of the country. The four major objectives of the CBI as stated in the Monetary and Banking Act of Iran (MBAI) are:

• Maintaining the value of national currency

• Maintaining the equilibrium in the balance of payments

• Facilitating trade-related transactions

• Improving the growth potential of the country

However, the CBI does not independently set monetary policy nor can it conduct proactive monetary policy. For example, the government, which is the main consumer of money, is in almost full control of the CBI – the main producer of money, with approval from the Majlis (The Iranian Parliament) required before the CBI can issue participation bonds.

Under the new administration, there is an acknowledgement of the need to reform the financial sector, including improving the independence of the CBI. However progress is likely to be slow, with disagreements between the administration and the Guardians Council on the level of independence necessary.

Key Points on Monetary Policy and the Financial Sector

 The sanction period had major implications on Iran’s foreign exchange rate and on its inflation rate

 The monetary policy framework has significantly improved under the Rouhani administration

 The stronger monetary policy environment, combined with the lifting of supply constraints following the JCPOA, have resulted in the easing of inflationary pressures on the economy

 The design of a flexible inflation-targeting framework is currently under consideration by the CBI, with underlying exchange rate and broad money growth anchor targets

 The ratio of non-performing loans (NPLs) in the banking system has improved in recent years but the high level remains a concern  Bank profitability has sharply declined relative to the pre-sanction level

 Thanks to the lifting of the sanctions, the Tehran Stock Exchange (TSE) index has outperformed global indices

 Sinking oil prices have led to a further narrowing of Iran’s current account surplus in 2015

 Foreign exchange reserves were estimated at USD 117.5 billion in 2015, which was equivalent to 19.4 months of imports  In recent years, Iran has largely been unsuccessful in attracting foreign direct investment given the high level of idiosyncratic country risk and, most notably, because of sanctions

 While growth is projected to accelerate materially, a significant degree of uncertainty remains which, until resolved, will continue to hold down economic activity

 Economic growth is projected to accelerate in 2016-2017 partly on account of a surge in energy exports

 On the non-hydrocarbon side, consumption and investment are expected to increasingly contribute to growth

 With the economy rebounding, the associated reduction in the output gap is likely to exert inflationary pressures on the economy unless supply-side structural reforms are implemented

 The central government fiscal stance is forecasted to be slightly contractionary; visibility on the wider public sector stance is, however, limited

 The current account balance is projected to continue to deteriorate in 2016 – to post its first deficit since 2004 – but is projected to return to a surplus in subsequent years

Banking Service Instruments In Iran

The introduction of modern payment instruments can be traced back to early 1990s where commercial bank of Sepah launched its Aber Bank (Debit Card) and ATM services. Since then almost all Iranian banks have provided their customers with the card payment services focusing on cards with debit function and ATM services to tackle the problem of heavy branch traffics.

The interbank card switch (SHETAB) was introduced in 2002 and now all card issuing banks in Iran are connected to the center; building up a uniform card payment network where all issued cards are accepted in all acquiring terminals.

Previously, debit and credit cards in the country can only be used on ATMs or POS machines that were provided by the issuer bank. Shetab changed this and now allows debit and credit cards to be accepted at any ATM or POS terminals in the country, and even in online payment portals. As a result, Iran is now one of the countries with the highest Debit Card penetration rate at 92%. Credit Card penetration however remains low, at only 3.1%. Further, online monthly transactions in the country have grown during the last years, as more customers use their debit and credit cards to pay online.

SWIFT Network and Iran Banking System

SWIFT (the Society for Worldwide Interbank Financial Telecommunication) is used by nearly every bank around the world to send payment messages that lead to the transfer of money across international borders. It provides a wide range of services including transmitting letters of credit, payments and securities transactions among 9,700 banks across 209 countries.

However, in March 2012 Iranian banks were disconnected from the system after the implementation of the US-led sanctions against the country. Accordingly, all 30 Iranian banks were blocked from using SWIFT services, literally cutting Iran off from the global banking system. The implication on the currency was significant, with the TSE/Parallel based Rial depreciating by more than half.

A key part of the recent negotiations of the JCPOA, included the resumption of access by both the CBI and Iranian financial institutions to the SWIFT network.

Following its implementation in January 2016, most Iranian banks have been reconnected to the SWIFT network and can engage in international transactions. However foreign banks remain concerned about doing business with Iran, as the US still retains sanctions in place which predate the nuclear crisis and worry they could still be targeted by the United States.

Re-engagement with the banking world through the SWIFT system is vital for Iran’s trade, particularly for the country’s oil exports and broader stability of its currency. Whilst we expect progress to be slow at first, the signs are positive. Anecdotally, Germany’s DZ Bank, Belgium’s KBC and Austria’s Erste Bank, Oberbank and Raiffeisen Bank International have already commenced cross boarder transactions for their clients in one form or another.

It is prudent to highlight that as long as the 1995 trade embargo by the US remains in place, no US Dollar transfers will be able to take place, as these transactions are required to be cleared in the US.

Iran Banking and Globalization

In 2001, 57 branches of private and governmental Iranian banks were active in foreign countries. The number fell to 49 in 2005, and following sanctions all overseas branches were closed. Post the implementation of the JCPOA, more than 50 branches of Iranian commercial banks are expected to restart their activities in foreign countries. Considering the capacity of current Iranian banks, it is anticipated that Saderat, Melli, Sepah, Mellat and Tejarat have the greatest potential to increase their international exposure with other global banks, regaining their position within international markets. Furthermore, Saderat, Mellat and Tejarat are among the private banks with the biggest potential at the global level.

The answer to whether Iran has really been readmitted to the SWIFT (Society for Worldwide Interbank Financial Telecommunication) system is complicated: The reconnection process to SWIFT has been physically established, however, few major foreign banks have decided to engage with Iran at this point. The banks that were actively trading even during the sanctions era continue to maintain their business, although nothing has so far changed for the bigger banks.

In fact, the nuclear deal says non-U.S. banks may resume trading with Iran, however because Washington retains sanctions against Iran that predate the nuclear crisis and were imposed over other issues such as human rights, bankers are uncertain of the legal basis for business and worry they could still be targeted by U.S. officials.

Conversely, after sanction relief, many foreign banks are keen to operate in Iran. Before the sanctions banks had demanded to establish branches in Iran (especially in free zones), those demands were met with the allowance for limited operations of some joint branches between foreign and Iranian banks.

There are now several requests from European banks, including Austrian, Italian and Lebanese banks, to start official activities in Iran. Further, ICBC China, the largest bank in the world, has requested to establish several branches in Iran. Belgium’s KBC and Germany’s DZ Bank both confirmed that they have started handling transactions on behalf of European clients doing business in Iran. Austria’s Erste Bank is also preparing to do so.

In theory, remaining sanctions (US sanctions applied for alleged terrorism and human rights violations) do not prevent international financial institutions from engaging with Iran, however there is still uncertainty for European banks that create unwanted ambiguity.

Despite these ambiguities, Iranian officials emphasize that there is no problem for international banks to receive permission for activity in Iran, and claim that it is not a time-consuming procedure.

On the other hand, Iranian banks are worried about the global competition. Most of them are far from the international standards and they have concerns on their ability to compete with big international banks in a global competitive atmosphere.

Based on the Iran Foreign Investment Promotion Act, foreign banks are allowed to hold a 40% share of Iranian banks and according to the Iranian Central Bank. The necessary initial capital for foreign investors to establish a bank in Iran is at 5 million EUR.

Iranian officials are trying to pass a number of laws to foster the establishment of foreign banks in Iran. As an example being that the Iranian government has prepared a bill that allows foreign banks to operate in Iran under 100% ownership.

Foreign Banks in Iran

The minimum capitalization for establishing a foreign bank branch in Iran is EUR 5 million. A handful of foreign bank branches and representative offices in the country were allowed to undertake administrative and coordination activities but were not permitted to open customer accounts inside the Iranian mainland territory, receive deposits or extend normative facilities.

In 2010, the Iranian government lifted a cap on the percentage ownership in Iranian banks that can be held by a foreign individual or company. The original law, which applied to both Iranians and foreigners, restricted the amount of shares in a bank that a single entity could own to 10% and an individual to 5%. According to the new rules, only the Iranian government has the authority to form joint banks with foreign entities.

According to the CBI, in 2016 five foreign banks have started operating in Tehran and Kish free trade zone.

Kish Free Trade Zone

Whilst still complying with Islamic Banking Laws, there are few other restrictions on activities of foreign banks in Iranian free economic zones. Additionally, the government has provided a number of incentive schemes to encourage investment including:

• 20 year tax-exemption

• Flexible employment regulations

• Extended legal guarantees and protections

• 100% foreign ownership

They may also open branches and representative offices in the mainland or hold 40% shares of an independent unit.

Conclusion & Outlook

This white paper gives a brief introduction to Iran’s Banking Industry. Key figures and facts in regards to the industry include:

 The Iranian banking system is large, with total assets of near 150 percent of GDP in 2010

 The banking industry is one of the Iran’s major industries, contributing 2.5% of GDP, and will play a vital role in enabling local businesses with international economies

 Iran has the second highest banking penetration rate in the MENA region

 Banks’ market share (or percentage of total system assets) have changed considerably in recent years owing largely to a series of partial privatizationslaunched by the Government

 Iran is the only Muslim country besides Sudan where the entire financial industry is obliged to be consistent with the principles of sharia law, accounting for more than 40% of the world’s total Islamic banking assets

 Strong local banking infrastructure, high debit card and smartphone penetration rates, combined with Iran’s young and well educated population of nearly 80m people, make this market an attractive prospect for FinTech entrepreneurs

Improving the Banking Industry is the first and most important step for the Iranian government to increase the impact of the JCPOA and achieve the goals set forth in the 2025 Vision* throughout all industries. The sector is expected to benefit from the lifting of the sanctions enforced from 2012, most notably via the reconnection to the SWIFT network and lending growth should pick up towards the latter half of 2016. Nevertheless, other historic US led sanctions remain and will likely limit the short-term positive impacts. The first milestone to the stabilization of Iran's banking sector has been achieved, but a boom in the lending and deposit market is not expected for several years.

In conclusion, even after the implementation of the JCPOA, many challenges remain for the Iranian Banking industry. It is our strong belief that come the beginning of 2017, this situation will be normalized. Some European and Asian banks will be offering full services to their Iranian customers and some of the governmental and private Iranian banks will be open and operational in Europe and Asia. The banking industry of Iran is going to grow at a fast peace, but certain challenges need to be dealt with.